U.S. Debt Ceiling Drama and Scenarios for Markets
Bottom Line: Tensions will likely grow dramatically in the next few weeks and one or more rating agencies could put the U.S. on negative outlook given the lack of political will for a reasonable deal in Congress. The most likely scenarios are that a deal will be reached or that the Biden administration will bypass Congress to avoid default (Figure 1). However, our probabilities are ballpark, as the situation is fluid and we will review the scenarios in a couple of weeks.
U.S. debt ceiling negotiations are progressing slowly. Meanwhile, financial markets assume default will be avoided, with tensions only seen in some t bill yields. What will happen?
Market Implications: If a deal is reached then the focus switches back to the macro and policy picture and this could see rate cuts expectations trimmed. Prolonged uncertainty with Biden bypassing Congress would hurt U.S. equities and the USD initially, although U.S. Treasuries would be impacted by safe haven flows as well as rating downgrade prospects for the U.S. government – downgrade risks are high in this scenario. A temporary coupon or principal default would be a disaster for U.S. financial markets.
Figure 1: Scenario Analysis for Financial Markets
Baseline—50% | Prolonged Uncertainty—30% | Worst Case downside—10% | |
Deal To Extend Debt Ceiling | Biden Bypasses Congress | Temporary U.S. Default | |
U.S. Debt Ceiling | Deal eventually done to lift the debt ceiling, but for 1 year or to early 2025 after the presidential election. This could include back loading expenditure restraint. Near year expenditure cuts would likely not hurt the U.S. economy materially. Additionally, this could have to be resolved by moderates on both sides, which would cause internal party tensions for the future in the Democrat and Republican parties. Market Implications: Market focus switches to other issues including Fed policy and U.S. economic and inflation trajectory. Early Fed cuts less likely could see a modest rise in U.S. Treasury yields and less expectations on 2023 rate cuts. USD rotates higher initially. Neutral for U.S. equities. | With no agreement, Biden administration bypasses Congress using the 14th amendment or a $1trn coin or premium bonds. Legal challenges would likely eventually go to the supreme court, which could take some time. Alternatively, Biden administration makes temporary sharp expenditure cuts due to desire to avoid default, but also to pressure for a deal. This could then be followed by a deal or bypassing Congress via the routes above. Rating agencies could downgrade the U.S. by one notch on concerns over lack of political consensus on the debt ceiling. Market Implications: U.S. equities hurt and S&P500 down to 3800 and USD lower. Mixed impact on U.S. Treasuries, with safe haven flows v downgrade. | After reaching the debt limit and exhausting all short-term financing tricks, temporarily U.S. delays coupon and/or debt repayments – an effective default. Rating agencies then review for potential multi notch downgrade. Global investors review structural U.S. Treasury holdings. Market Implications: Multi notch downgrade would cause a surge in U.S. Treasury yields initially, before Fed rate cuts due to the damage for the economy. Equities see sharper fall to 3500 initially and USD hurt more noticeably. |
Source: Continuum Economics. Other solutions are 10% (though unlikely) such as the Democrats caving in to accept GOP house bill for substantive expenditure cuts.
2023 Not Like 2011
As we recently highlighted the backdrop to the 2011 debt ceiling crisis was better than now (here), due to the backstop of the sequester expenditure cuts, when Republicans accepted cuts to defence, that delivered an agreement to raise the debt ceiling on July 31 2011, but is not something either side wants to repeat. This then means that the stakes are very high going to X date, which could come as soon as June 1 (CBO has warned that it could be within the 1st two weeks of June), when special measures are projected to run out and the risk of a default on future coupon or principal repayments rises rapidly.
Our central view remains that the U.S. will avoid a default on any part of its debt, as the consequences on the U.S. financial sector and economy would be severe. We attach a 10% probability to this worst case scenario (Figure 1) and will return to review the consequences below. However, what about the other 90% of probabilities?
The two main scenarios are either a deal being struck (50%) or the Biden administration bypassing Congress and the debt ceiling (30%). The remaining 10% reflects low probability solutions such as the Democrats caving in and completely accepting the House bill that would cause politically painful aftershocks for the Democrats. The problem is that the path to achieving a deal is difficult, as current negotiations are slow and failing to achieve credible common ground. Eventually a deal could be struck involving some expenditure cuts as the 2011 deal did, potentially back loaded until after the 2024 presidential election to reduce the political fallout for both parties. This could require moderate Republicans to agree a deal with the Democrats and bypass McCarthy and the bulk of House Republicans. However, a lot of political drama is required before this point is reached, including potentially a fall in the U.S. equity market.
However, the experience in 2011 was that the wider financial market shock came after the deal, both as the U.S. quickly increased debt by $238bln on August 3 and S&P downgraded the U.S. by one notch on August 5.U.S. equities fell sharply (Figure 2) on concerns of further fiscal tightening and downgrading ramifications, but U.S. Treasury yields fell on safe haven flows and economic slowdown concerns (Figure 3).
Figure 2: S&P500 Selloff Came After the 2011 Deal and On S&P Downgrade (Index)
Source: Datastream/Continuum Economics
Figure 3: 10 and 2yr U.S. Treasury Yields Drop on Economic Worries/Safe Haven (%)
Source: Datastream/Continuum Economics
T Bill yields for June-July are very elevated already, but wider financial markets have taken the view that a deal will eventually be done. It require a catalyst for wider financial strains to come through, such as a complete breakdown of talks or alternatively one or more major ratings agencies putting the U.S. government on downgrade outlook. In 2011, S&P actually put the U.S. on downgrade outlook 2 ½ months before X date and so the risk of similar action is rising – especially from Moody and Fitch that have the U.S. on AAA. The drama over the U.S. debt ceiling will likely spiral in the remainder of May/early June.
A difference exists for financial markets in the two main scenarios. A deal would be regarded as a reason for moving back to looking at the U.S. growth/inflation and Fed policy outlooks. Though any deal would likely only raise the debt ceiling until before or just after the November 2024 presidential elections, the market would be less focused on medium-term debt concerns. Expenditure cuts in the near years would also likely be modest and not have a material effect on the U.S. economy. It could mean that expectations of 2023 Fed rate cuts are tempered and a small/modest rise is seen in U.S. Treasury yields given the discount to the Fed Funds rate.
The 2nd scenario would be the Biden administration bypassing Congress. One solution to avoid default is invoking the 14th amendment (section 4) to bypass Congress and the debt ceiling, but this would still be modestly adverse to the U.S. economy and business/consumer sentiment. Bypassing the debt ceiling and Congress would likely cause a major legal challenge that would eventually go all the way to the Supreme Court – some argue that 14th amendment section 5 guides that Congress should be in control of debt. This would cause economic uncertainty. Additionally, it could mean a yield premium is required on U.S. Treasuries until the Supreme Court ruled on the 14th amendment being used, which could take 2 months. Biden could choose this route if he feels an unpopular Supreme Court would uphold this route and be willing to overlook Republican claims that democracy was being undermined. A 2nd alternative is for the U.S. Treasury to mint one or two $1trn coins and deposit for cash at the Fed. The problem is would the Fed then print the money and not neutralize (risking inflation) or consider neutralizing liquidity that could including potential accelerated sales of U.S. Treasury holdings! This would shift the story to a U.S. Treasury/Fed dimension. Either of these solutions could be modestly bad for U.S. equities and would likely cause a selloff in the S&P500 to 3800, but the outlook would then depend on whether the Supreme Court is expected to back the Biden administration or not or alternatively whether the Fed smoothly deals with the $1trn coin option. A 3rd alternative is for the U.S. Treasury to issue huge amounts of premium bonds with low coupon and below par initial value, but for a modern sovereign this could hurt credibility.
Much would also depend on the reaction of the rating agencies, as they could regard any of these solutions as demonstrating a lack of political will and ability to address the debt trajectory properly. The risks would then be high of a downgrade for the U.S. by one notch by one or more of the rating agencies over the summer. The 2011 S&P downgrade was motivated by these concerns, while Fitch recently quickly downgraded France one notch due to political turmoil surrounding debt and raising retirement age (here). However, the actual reaction of U.S. Treasuries to a one notch downgrade by one rating agency is unclear.2011 actually saw U.S. Treasury yields falling on safe haven flows from equities helped by the fact that a debt ceiling deal had been done. Other major DM governments have ratings below the U.S. (Figure 4) without much long-term consequence (e.g. UK/Japan) or have been downgraded without much market reaction (e.g. France). It could lead to the short-end performing better than the long-end, but this is not certain given the current large discount of 2yr yields to the Fed Funds rates.
Figure 4: Ratings of Select Major DM Countries (%)
S&P | Moody's | Fitch | |
Belgium | AA | Aa3 | AA- |
Canada | AAA | Aaa | AA+ |
France | AA | Aa2 | AA- |
Japan | A+ | A1 | A |
Spain | A | Baa1 | A- |
United Kingdom | AA | Aa3 | AA- |
United States | AA+ | Aaa | AAA |
Source:Rating Agencies/Continuum Economics
The worst case scenario of the U.S. government delaying coupon or principal payments would be a watershed even if it was temporary in order to force Congress to strike a deal. Though some commentators say it would only have a short-term effect and that a temporary delay would not be a full scale default, the U.S. financial system is dependent on the kindness of strangers. IMF estimates are that 27% of U.S. Treasuries are held by foreign holders, while the foundations of the USD reserve status are dependent on the liquidity and standing of the U.S. government and U.S. Treasury. Experience shows that sovereign domestic default is rare (usually the central bank prints money to boost inflation), but when it occurs it leads to a rise in yields as risk premia increase.
A temporary default by the U.S. could likely trigger either a one notch downgrade by rating agencies and remaining on downgrade watch or a multi notch downgrade. A multi notch downgrade would be a disaster, as it could cause liquidation of foreign holdings of Treasuries and at least a temporary surge in U.S. Treasury yields.Given the government rating is a ceiling for most borrowers, the risk would be collective downgrades for U.S. entities and a broad credit crunch – likely amplified by a 3rd wave of problems in the regional banking system (here). This would be a big set of shocks to the U.S. economy and earnings prospects that would likely cause a sharp selloff to 3500 in the S&P500. The USD would be hurt in this scenario, with safe havens elsewhere being the beneficiaries given it would cause global risk off.